An investment company (hereinafter “investment fund”) is a company (corporation, business trust, partnership, or limited liability company) that is primarily engaged in the business of investing in securities. The investment fund issues shares that are bought by investors and then invests the money received from the investors on a collective basis. The investment fund's performance is based upon the performance of its investments in securities and in other assets. Each investor proportionally shares in the investment fund's profits and losses. The value of an investment fund's shares is measured by adding up the value of the securities and any other assets it owns, subtracting liabilities, and dividing by the number of outstanding shares. This figure is known as the investment fund's “net asset value” (NAV). It is typically calculated once per day, at the close of the financial markets.
There are three types of investment funds: open-end funds, closed-end funds, and unit investment trusts (UITs). Open-end funds generally sell shares on a continuing basis, and investors purchase shares from the open-end fund itself. Closed-end funds do not continuously offer their shares for sale, but instead sell a fixed number of shares at an initial public offering, after which the shares typically trade on a secondary market, such as the New York Stock Exchange or the Nasdaq Stock Market. A UIT typically will make a one-time public offering of only a specific, fixed number of units (like closed-end funds). Many UIT sponsors maintain secondary markets for trading UIT units.
The shares issued by open-end funds and the units issued by UITs are redeemable, i.e., they can be tendered back to the fund or a broker acting for the fund in exchange for cash (or in rare cases securities) at the NAV. Closed-end fund shares are generally not redeemable but, as mentioned above, often may be sold on a secondary market at a price determined by the market.
Share redemptions in which shares are tendered back to an investment fund in exchange for cash may result in transaction costs incurred by the investment fund. When investment fund managers have to sell securities, the investment fund incurs transaction costs and, potentially, realizes capital gains. Over time, transaction costs and realized capital gains negatively affect the performance of the investment fund and significantly reduce the return on investment and the after-tax return of taxable investors. Thus, investment fund managers strive to minimize transaction costs and realization of capital gains to maintain the investment fund as an attractive investment for investors. One method for achieving efficiency is effected by placing restrictions on trading shares to prevent market timing or otherwise restricting cash flow. Such restrictions might prohibit a person or institution who has a short time horizon from purchasing shares in the investment fund. In this way, an investment fund may discourage market timing.